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Errors in estimating the discount rate or mismatching cashflows and discount rates can lead to serious errors in valuation. * At an intutive level, the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted. I. Cost of Equity The cost of equity is the rate of return that investors require to make an equity investment in a firm. There are two approaches to estimating the cost of equity; * a risk and return model * a dividend-growth model. Models of Risk and Return The Capital Asset Pricing Model * Measures risk in terms on non-diversifiable variance * Relates expected returns to this risk measure. * It is based upon several assumptions (a) that investors have homogeneous expectations about asset returns and variances (b) that they can borrow and lend at a riskfree rate (c) that all assets are marketable and perfectly divisible (d) that there are no transactions costs and that there are no restrictions on short sales. Risk in the CAPM Beta: The non-diversifiable risk for any asset can be measured by the covariance of its returns with returns on a market index, which is defined to be the asset's beta. The cost of equity will be the required return, Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf) where,

Rf = Riskfree rate E(Rm) = Expected Return on the Market Index Using the Capital Asset Pricing Model * Inputs required to use the CAPM (a) the current risk-free rate (b) the expected return on the market index and (c) the beta of the asset being analyzed. Practical issues in using the CAPM -1. Measurement of the risk premium * It is generally based upon historical data, and the premium is defined to be the difference between average returns on stocks and average returns on riskfree securities over the measurement period. Magnitude of the risk premium Historical Period 1926-1990 1962-1990 1981-1990 Stocks - T. Bills Arithmetic 8.41% 4.10% 6.05% Geometric 6.41% 2.95% 5.38% Stocks - T.Bonds Arithmetic 7.24% 3.92% 0.13% Geometric 5.50% 3.25% 0.19%

*** Generally, geometric averages provide better estimates of risk premiums in valuation.
**

y

The risk premiums will vary across markets, depending upon their riskiness. While historical data can be used to estimate premiums outside the United States, it is not very reliable. An alternative way of estimating premiums is to use country bond ratings to estimate these premiums relative to the U.S. premium. For instance, the risk premiums for South American countries can be estimated as follows: Rating BBB BB Risk Premium 5.5% + 1.75% = 7.25% 5.5% + 2% = 7.5%

Country Argentina Brazil

50%) = 14.50% at the same point in time ñ Cost of Equity (British Pounds) = 8.10 at the end of 1994. it may make sense to look at the rate at which large corporations can borrow in the local market.65. Riskfree Rate The long-term government bond rate is the appropriate riskfree rate.5% + 2.10 (5. That would be double counting. Illustration 3: Using the CAPM to calculate cost of equity Glaxo Holdings had an estimated beta of 1.1% A Warning: If you add a default premium to the risk premium.00% + 1.05% This is the cost of equity. Which beta would you use in valuing Glaxo? .5% + 0. When the long term government bond rate is not available. Wellcome has a beta of 0.75% = 6.25% = 6.00%. y Wellcome is planning an acquisition of Glaxo.75% 5.6% = 7.5% + 1.50% + 1.Chile Columbia Mexico Paraguay Peru Uruguay AA A+ BBB+ BBBB BBB 5. which was 8.25% 5.5% = 8% 5.. the thirty-year treasury bond rate in the United States was 8. II. The estimated cost of equity for Glaxo in December 1994 was ñ Cost of Equity = 8. if cash flows are estimated in dollars. At the same point in time.5% = 7% 5.K.55% This difference reflects differences in expected inflation in the two markets.5% + 1.5% + 1. The same estimation can be done in British Pounds.75% = 7.10 (5.25% 5. do not add a risk premium to the risk free rate.50%) = 14. using the long term Government Bond rate in the U.5% + 1.

other things remaining equal. It had research and development expenses which were 670% of sales in 1994. What would the impact of these actions be on pharmaceutical firmsí betas? II. or because of the nature of their business. and is usually defined in terms of the relationship between fixed costs and total costs.e. then. (Synergen. (Wellcome is a good example. either through acquisitions or through projects. had a beta of 1.65 in 1994. the higher is its beta. Financial Leverage: * An increase in financial leverage will increase the equity beta of a firm.. and debt has a tax benefit to the firm. Type of Business: * The more sensitive a business is to market conditions. Levered Beta = Unlevered Beta (1 + (1-t) (D/E)) . either because they focus heavily on research. i. there are some firms which have very high fixed costs. * A firm which has high operating leverage -> higher variability in earnings before interest and taxes (EBIT) -> higher beta y Sticking again with pharmaceutical firms.Determinants of Betas I.) These firms will have higher betas than other firms which have more traditional cost structures. * The beta of a firm is the weighted average of the betas of its different business lines.) III. Degree of Operating Leverage: * DOL is a function of the cost structure of a firm. the beta of debt is zero. for instance. than non-cyclical firms. * If all of the firm's risk are borne by the stockholders. Biotechnology firms have an average beta of 1. Thus cyclical firms can be expected to have higher betas. y Pharmaceutical companies are increasingly looking at expanding into biotechnology.8.

07 New Levered Beta = 1. had a debt/equity ratio of 4% in 1994. The betas of publicly traded firms involved in office equipment and supplies are as follows (They face an average tax rate of 40%). with a beta of 1.45 1.97 Debt/Equity 0.95 0.80 0.05 0.7*0.03 0.10 /(1+0.20 0.10 0.22 Other approaches to estimating Betas I.17 .00 0.7*0.where. its beta would be much higher (Tax rate was 30%) ñ Current Beta (Levered) = 1. If Glaxo were to raise its debt/equity ratio to 20%.04) = 1.90 1.20 0. * Correct for differences in financial leverage between the firm being analyzed and the comparable firms.10. t = Corporate tax rate D/E = Debt/Equity Ratio Illustration 4: Effects of Financial Leverage on Betas Glaxo. The private firm had a debt/equity ratio of 30%. Using comparable firms: * Use the betas of publicly traded firms which are comparable in terms of business risk and operating leverage.07 (1+0. Illustration 5: Using comparable firms to estimate betas Assume that you are trying to estimate the beta for a private firm that is in the business of manufacturing. selling and servicing fax machines.10 Unlevered Beta = 1. Firm General Binding Hunt Manufacturing Moore Coroporation Nashua Company Pitney Bowes Average Beta 1.2) = 1.

with the following financial characteristics (defined consistently with the regression): Coefficient of Variation in Operating Income = 2.9832 + 0.04 II.2 Dividend Yield = 0.3)) = 1.88 Beta for private firm involved in office supplies = 0.97 / (1 + (1-0. size.4) (0.00001 Total Assets where.30 Total Assets = $ 10.30 Growth in Earnings per share = 0. * Income statement and balance sheet variables are important predictors of beta * Following is a regression relating the betas of NYSE and AMEX stocks in 1991 to five variables .Unlevered Beta of office supply firms = 0. .17)) = 0. Using fundamental factors: * Combines industry and company-fundamental factors to predict betas.034 Growth in Earnings per Share .0. BETA = 0.88 (1 + (1-0.126 Dividend Yield + 0.15 Debt/Equity Ratio + 0.0.dividend yield.4) (0. debt/equity and growth in earnings. coefficient of variation in operating income.000 (in thousands) The estimated beta for this firm.04 Debt/Equity Ratio = 0. CV in Operating Income = Coefficient of Variation in Operating Income = Standard Deviation in Operating Income/ Average Operating Income Illustration 6: Using fundamental information to predict betas Assume that you are trying to estimate the beta for a private firm.08 CV in Operating Income .

with a beta specific to each factor. Riskfree rate = 3.BETA = 0.00001*10. however.04 + 0.30 . the cost of equity can also be estimated. Rf = Riskfree rate Fj = Beta specific to factor j E(Rj) .30 + 0. If these factor-specific betas and the factor risk premia can be estimated. and that there are three factors.Rf = 1.Rf = Risk premium per unit of factor j risk k = Number of factors Using the Arbitrage Pricing Model Illustration 7: Using the APM to estimate the cost of equity Assume that the parameters for the arbitrage pricing model have been estimated. * The arbitrage pricing model relates expected returns to economic factors..5% : Risk Premium for factor 3 Assume that the betas specific to each of these factors are estimated for Pepsi Cola in 1992 and .2 .35% E(R1) .0.126* 0. is not a single factor but is determined by an asset's sensitivity to various economic factors that affect all assets. i.19 The Arbitrage Pricing Model * Logic behind the arbitrage pricing model (APM) same as the logic behind the CAPM.034 * 0.15* 0.Rf = 4% : Risk Premium for factor 2 E(R3) .08*2.9832 +0. where.000 = 1. * The number and the identity of the factors are determined by the data on historical returns.0.e.Rf = 3% : Risk Premium for factor 1 E(R2) . investors get rewarded for taking on non-diversifiable risk. * Measure of this non-diversifiable risk in the APM.

changes in default premium. Multi-factor Models for risk and return * Unidentified factors in the arbitrage pricing model are replaced with macro-economic variables. These variables can then be correlated with returns to come up with a model of expected returns.20% Considerations on the use of the APM * Capital asset pricing model can be considered to be a specialized case of the arbitrage pricing model.35% + 1.20 F2 = 0. unanticipated inflation and changes in the real rate of return. * Costs of going from the arbitrage pricing model to a macro-economic multi-factor model can be traced directly to the errors that can be made in identifying the factors. * The factors in the model can change over time. with firm-specific betas calculated relative to each variable. * For example. the CAPM has the advantage of being a simpler model to estimate and to use. Cost of Equity = 3. but it will underperform the richer APM when the company is sensitive to economic factors not well represented in the market index.90 F3 = 1. where there is only one underlying factor and that underlying factor is completely measured by the market index. Example: Oil companies.5%) = 12. Roll and Ross (1986) suggest that the following macroeconomic variables are highly correlated with the factors that come out of factor analysis -.20 (3%) + 0. * In general. * The biggest intuitive block in using the arbitrage pricing model is its failure to identify specifically the factors driving expected returns. Chen. shifts in the term structure.10 Substituting into the APM. which derive most of their risk from oil price movements.that the estimates are as follows: F1 = 1. .90 (4%) + 1.1 (1.industrial production. tend to have low CAPM betas. as will the risk premia associated with each economic factor.

* Using the wrong factor(s) or missing a significant factor in a multi-factor model can lead to inferior estimates of cost of equity. Southwestern Bell paid dividend per share of $2. using this cost of equity. Dividend Growth Model For a firm which has a stable growth rate in earnings and dividends.82 *1.g) where. the present value of a share of equity can be written as: Po = Present Value of expected dividends = DPS1 / (ke . P0 = Price of the stock today DPS1 = Expected dividends per share next year ke = Cost of Equity g = Growth rate in dividends (steady state) A simple manipulation of this formula yields. since the current price is a key input to the model.055 = $2. it is inappropriate to use this approach to value stock in a firm. that equity is fairly valued.5% .98 / $66 + 5. ke = DPS1 / P0 + g = Expected Dividend Yield + Growth rate in earnings/dividends More importantly. There is a strong element of circular reasoning involved that will lead the analyst to conclude.82 and the stock traded at $66 in December 1992. Expected Dividends in 1993 = $2. The estimated growth rate in dividends is 5.5% and the firm is assumed to be in steady state. The dividend growth model can then be used to estimate the cost of equity.98 Cost of Equity = $2. Illustration 8: Using the Dividend Growth Model to estimate the cost of equity: Southwestern Bell In 1992.

In December 1994. . WACC = ke ( E/ (D+E+PS)) + kd ( D/ (D+E+PS)) + kps ( PS/ (D+E+PS)) where. Weighted Average Cost of Capital (WACC) Definition of the Weighted Average Cost of Capital (WACC) The weighted average cost of capital is defined as the weighted average of the costs of the different components of financing used by a firm.00%+1.00%. Genzyme Corporation had * a beta of 1.60 (5.= 10% To illustrate the circular reasoning involved in using this cost of equity to value stock.50%) = 16. This results in Cost of equity = 8.60.80% * an after-tax cost of debt of 6.055) = $66 Not surprisingly.00%. Value of Equity = $ 2.30%. Tax rate=30%) * Equity comprised 85. the stock is found to be fairly valued. WACC = Weighted Average Cost of Capital ke = Cost of Equity kd = After-tax Cost of Debt kps = Cost of Preferred Stock E/(E+D+PS) = Market Value proportion of Equity in Funding Mix D/(E+D+PS) = Market Value proportion of Debt in Funding Mix PS/(E+D+PS) = Market Value proportion of Preferred Stock in Funding Mix Illustration 9: Calculating the Cost of Capital: Genzyme Corporation. (Pre-tax cost of debt=9.98 / (..10 .00% (in market value terms) of the funding mix and debt made up the remaining 15.

15) = 15.23 % ESTIMATION OF CASH FLOWS Cash flows to Equity for a Levered Firm Revenues .Interest Expenses = Earnings before taxes .Operating Expenses = Earnings before interest.Depreciation & Amortization = Earnings before interest and taxes (EBIT) .85) + 6.Taxes = Net Income + Depreciation & Amortization = Cash flows from Operations .* The cost of capital for Genzyme can then be calculated as follows: WACC = 16.Capital Expenditures . taxes and depreciation (EBITDA) .Principal Repayments + Proceeds from New Debt Issues = Free Cash flow to Equity Levered Firm at Desired Leverage Net Income .30% (0.80% (0.Working Capital Needs .Preferred Dividends .

(Cap Ex .5 billion in debt outstanding and $ 9 billion in market value of equity. and sales are expected to increase from $6420 million in 1994 to $7100 million in 1995. The companyís working capital increased to $225 million in 1994 from $203 million in 1993.00 $ 156.DR) (Capital Expenditures .(1.00 Net Income . The company reported depreciation of $180 million in 1994 and is expected to have depreciation of $200 million in 1995. (How does one know?) The company reported net income of $695 million in 1994 and is projected to have a net income of $765 million in 1995.Depreciation) .92 $ 519.DR) Working Capital Needs = Free Cash flow to Equity For this firm. This debt ratio is assumed to be stable..(1.( Change in Working Capital) (1-DR) FCFE Proposition : The Free Cash Flow to Equity will increase as the amount of debt financing used by the firm increases. leading to a debt to capital ratio (ìdebt ratioî) of 14%.56 Estd 1995 $ 765.52 $ 18. y y y y y The company had $1.50 $ 172. . Proceeds from new debt issues = Principal Repayments +DR (Capital Expenditures Depreciation + Working Capital Needs) Illustration 10: Estimating the cash flow to equity for a firm at its desired leverage: WarnerLambert The following is an estimation of free cash flows to equity for Warner-Lambert in 1994 and for 1995 (projected).50 14%) $ 572. Thus FCFE will be an increasing function of _. 1994 $ 695. It is expected to maintain working capital at the same percentage of sales in 1995.Depreciation) (1-DR) .00 (DR = 14%) (DR = $ 20. The company had capital expenditures of $362 million in 1994 and is expected to have capital expenditures of $400 million in 1995.

Warner Lambert Corporation The following are the cash flows to equity for Warner Lambert.Capital Spending .tax rate) + Depreciation .( Change in Working (DR = $ 13. 1994 Estd 1995 Net Income $ 695.30 Capital) (1-DR) 40%) FCFE $ 572.Depreciation) (DR = $ 109.(Cap Ex .00 $ 765.00 .20 $ 14. using a debt ratio of 40% instead of a debt ratio of 14%.00 (1-DR) 40%) .Illustration 11: Sensitivity to Debt Ratio .20 $ 120.Change in Working Capital .60 $ 630.70 The following graph illustrates the effect on free cash flows to equity of changing the debt ratios from 0% to 100% ñ CASHFLOWS TO THE FIRM EBIT ( 1 .

0 and the current T. In addition. The expected inflation rate is 3% in both the firm's cash flows and the general economy.5%. in real terms. The valuation of this firm can be done on either a real or a nominal basis: The estimates of growth on a real and nominal basis are done first . The earnings before interest and taxes is expected to increase to 3.460 mil DM + Depreciation 4. prior to general provisions and extraordinary charges. as a German-based multinational involved in a wide range of businesses.560 million DM in 1992.613 million DM and capital expenditures of 5. The free cashflows to the firm for 1992 and 1993 (estimated) are provided below.967 million DM in 1993.405 million DM in 1992.Capital Expenditures 5.838 mil DM .159 mil DM 2.Change in Working Capital 1.Bond rate is 6.= Cash flow to the firm Illustration 12: Estimating the expected cash flow to the firm . reported earnings before interest and taxes of 3.098 mil DM 770 mil DM Free Cashflow to firm 114 mil DM 696 mil DM INFLATION AND VALUATION Consistency Principle 1: Nominal cash flows should be discounted at nominal discount rates. The firm has a beta of 1. Real cash flows should be discounted at real discount rates. 1992 Projected 1993 EBIT (1 . the working capital increased from 14.482 million DM in 1992. It had depreciation of 4. at 5% a year for the next three years and 3% a year after that.Siemens Siemens AG. depreciation and working capital are all expected to increase by 5% in 1993. Capital expenditures.306 million DM in 1991 to 15.560 mil DM 5.844 mil DM .tax rate) 2.613 mil DM 4. The firm had a tax rate of 38% in 1992. Illustration 13: The Effect of Inflation on Cash flows and Discount Rates Consider a firm which has cash flows to equity currently of $100 million and is expected to grow.

122 + ($126 + $2.12/1.12 + $ 117 / 1.. The present values of the cash flows to equity and the terminal value can then be calculated using the appropriate discount rate: Present value (using real cash flows) = $105/1.0874 ..03)-1 = 8.271 This calculation assumes that the growth rates after year 3 are steady state growth rates and will continue through infinity.078 Terminal value (Nominal Cash flows) = $ 126 * 1.0609) = $ 2.896 Present value (using nominal cash flows) = $108/1.896 Illustration 13A: The Effect of mismatching cash flows and discount rates Real Cash flows@ Nominal Nominal Cash flows@ Real rate rate .271 The terminal values are calculated as follows for real and nominal cash flows: Terminal value (Real Cash flows) = $ 116 * 1.0874 + $ 110 / 1. Using these growth rates the cash flows can be generated in both nominal and real terms: Real Cash flows Nominal Cash flows Terminal Nominal Cash Terminal Year CF to Equity Value flows Value 1 $105 $108 2 $110 $117 3 $116 $2.09% The discount rate can similarly be estimated on a real and nominal basis: Real Nominal Discount Rate 1.03) = $ 2.03)-1 = 6.5%.03 -1 = 8.5%) =12% The expected nominal return is estimated using the CAPM.Bonds of 5.15% Growth Rate after year 3 3% (1.74% E(R) =6.08742 + ($116 + $2.0609 / (.03 / (.08743 = $ 1. with a historical premium earned by stocks over T.271) / 1.123 = $ 1.12 .Real Nominal Growth Rate in first 3 years 5% (1.5% +1(5.03)(1.078) / 1.078 $126 $2.05)(1.

12 + $ 110 / 1.12-.0874 + $ 117 / 1. the present value is: Present value (nominal cash flows discounted at real rates) = $108/1. the present value is: Present value (real cash flows discounted at nominal rates) = $105/1.Rf) where.0609) = $ 5. After-tax cash flows should be discounted at after-tax discount rates.122 + ($116 + $1.03) = $1. E(Rj) = Expected pre-tax return on asset j Rf = Riskfree rate Fj = Beta of asset j .896 If nominal cash flows are discounted at the real discount rate.325 Terminal value (using real rate and nominal cash flows) = $ 126 * 1. Terminal value (using nominal rate and real cash flows) = $ 116 *1.03 / (.0874 -.08743 = $4.068 The terminal values are miscalculated because cash flows and discount rates are not matched.Year CF to Equity 1 2 3 $105 $110 $116 Terminal Value $1.068) / 1.08742 + ($126 + $5.325) / 1.207 < True value of $1.0609 / (.068 If real cash flows are discounted at the nominal discount rate.123 = $ 1. After-tax version of the Capital Asset Pricing Model E(Rj) = Rf + H+ HFj + H2 (Kj .896 TAXES AND VALUATION Consistency Principle 2: Pre-tax cash flows should be discounted at pre-tax discount rates.325 Nominal Cash flows $108 $117 $126 Terminal Value $5.293 > True value of $1.

20.79 4 $3.36 2 $2.12933 + $3.($93.1293 + $ 2.98/1.91 $93.43 .28 = $84.20 The initial price is assumed to be $62.27 $1.12932 + $2.41 The discount rate can be estimated before personal taxes and used to calculate the present value per share: Discount rate before personal taxes = 7.60 / 1.93% Present Value per share (based upon pre-tax cash flows and pre-tax discount rates) =$ 2.43 .05 and the treasury bond rate wass 7. The firm had a beta of 1.12934 + ($3.27/1.5%) = 12.15%.91+$93.45)/1.35 $84.05 (5.41/1. The cash flows on a pre and post tax basis are as follows: Before personal taxes After personal taxes Dividends per Terminal Dividends per Terminal Year share price share price 1 $2.56 3 $2.15% + 1.60 $1. The following example values Eli Lilly on the basis of cash flows after personal taxes for an investor with a tax rate of 40% for ordinary income and 28% for capital gains.Ordinary tax rate) Terminal price after taxes = Terminal price before taxes . The cash flows after personal taxes are estimated after personal taxes as follows: Dividends per share after taxes = Dividends per share before taxes * (1 .Initial price) * Capital Gains tax rate = $ 93.Kj = Dividend Yield of asset j H0 = A constant term H1 = Market premium for systematic risk H2 = Influence of dividend payout on expected returns Illustration 14: Effect of personal taxes on cash flows and discount rates: Eli Lilly The expected dividends and the terminal price were estimated for Eli Lilly at the beginning of 1992 for the next five years (before personal taxes).12935 = $ 62.20) * 0.05 5 $3.(Terminal price .98 $1.41 $2.41 The discount rate before personal taxes can be apportioned into dividend yield and price appreciation: .43 $2.$62.

35+$84.56% -11.79/1.40) + 9.11% 39.90 $0.71% (1 .20 Thus the value is unaffected by whether cash flows are before or after personal taxes. ESTIMATING GROWTH RATES I.20 = 3.0.Expected Dividend Yield = Expected Dividends next year/ Initial Price =$2.71% = 9. Estimating and Using Historical Growth Rates y y y Historical growth rates can be estimated in a number of different ways o Arithmetic versus Geometric Averages o Simple versus Regression Models Historical growth rates can be sensitive to o the period used in the estimation In using historical growth rates.22% (1 .0886 + $ 1.22% Discount rate after personal taxes = 3.86% Present Value per share (based upon after-tax cash flows and after-tax discount rates) =$ 1.05/1.66 $0.71% Expected Price Appreciation = Expected Return .28) = 8. starting in 1989 and ending in 1994: Year 1989 1990 1991 1992 1993 1994 EPS $0.08865 = $ 62.91 $1.36% 1.08863 + $2.13 $1.27 Growth Rate 36.41)/1.3.27 / $62.0. as long as the discount rates are adjusted accordingly.08862 + $1.Expected Dividend Yield = 12.93% .08864 + ($2.39% .27 $1.56 / 1.02% 12.36/1. the following factors have to be considered o how to deal with negative earning o the effect of changing size Illustration 15: Using arithmetic average versus geometric average: Autodesk The following are the earnings per share at Glaxo Pharmaceuticals.

11 -0.13 $1.24 Linear Regression : EPS = 0. and the linear and log linear regressions are done below: Time (t) 1 2 3 4 5 6 7 Year 1988 1989 1990 1991 1992 1993 1994 EPS $0.66 $0.27 ln(EPS) -0.13 $1.Arithmetic mean = (36. Time (t) 1 2 3 4 5 6 7 Year 1988 1989 1990 1991 1992 1993 1994 EPS $0.36%+1.02%+12.27 $1.99% Illustration 16: Sensitivity of historical growth rates to the length of the estimation period: Glaxo The following table provides earnings per share at Glaxo.09 0.11%+39..66)1/5 -1 = 13.27/0.91 $1.5171 + 0.68% Geometric mean = (1.32% Geometric mean = (1.27 $1.56%-11.81% Illustration 17: Linear and Log-linear models of growth: Glaxo Inc.1132 t .27 Arithmetic average = 13.65)1/6 -1 = 11.43 -0. starting in 1988 instead of 1989 and uses six years of growth rather than five to estimate the arithmetic and geometric averages.24 0.65 $0.90 $0.42 -0. The earnings per share from 1988 until 1994 is provided for Glaxo.66 $0.90 $0.65 $0.39%)/5 = 15.27/0.12 0.91 $1.

5536 + 0.5171 + 0. if earnings per share goes from <$1.28% 3 1990 $1.Log-linear Regression: ln (EPS) = -0.1225 t Expected EPS (1995) : linear regression = 0.06% -88.00/<$1.38% -37. the traditional growth rate measures would be ñ Arithmetic Growth Rate = = EPSt/EPSt-1 -1 = $1.00> .00% 7 1994 $0.67 -0.55% 4 1991 $0.34 -1.00> = -100% There is a solution to this problem.77 0.1225 (8)) = $ 1.00.07 -39.55% -39.56 1.40 -37. The following series lists earnings per share from 1988 to 1994 for Sterling Chemicalsñ Growth Modified Time (t) Year EPS log(EPS) Rate Growth Rate 1 1988 $3. Modified growth rate =(EPSt-EPSt-1)/Max(EPSt.27 2 1989 $1.08 129.00> to $1.55536 + 0.42 Expected EPS (1995): log-linear regression = e (-0.00% . since the traditional growth rate measures often fail. For instance.28% -50.00% 225.EPSt-1) Illustration 18: Dealing with negative earnings: Sterling Chemicals.41% 440.07 0.10) NMF -225.08 -2.53 -88.53 Dealing with negative earnings Calculating growth rates when earnings become negative is problematic.1132 (8) = $1.1 = -200 % Geometric growth rate = $1.38% 5 1992 $0.06% 6 1993 ($0.57 -50.00/<$1.

but do not do much better than such models over the long term.48% Approach 2: Using the minimum or maximum of earnings as the denominator Arithmetic average. in both percentage and dollar terms.494.5139 t Average EPS (1988-94) = $ 1.407. Analystsí Forecasts Of Earnings: How Good Are They? Studies indicate that analysts do better than mechanical models at forecasting earnings in the short term. The following table shows the growth in net income for Amgen from 1989 to 1994.1 million in 1989 to $430 million in 1994.785.10 1991 $186.10 Geometric Average Growth Rate = 86.51.63 86.0.67 86.32 86.20 351.291.60 86.06 Growth rate = .40 1993 $354. % Growth Æ Net Year Net Income Rate Income 1989 $19.487.70 64.10 1990 $86.5139 / 1.31 1999 $9.98 86.30 116.63% $120.42% Assuming that this growth rate continues for the next five years.0.72 1997 $2.90 15.35 1998 $5. using modified growth rates = .680. % Growth Æ Net Year Net Income Rate Income 1995 $801. .65 II.16% $75.20 1994 $430.72% $48.13% $100.42% $692.31% $67.10 1992 $306.Approach 1: Using the slope coefficient from the linear regression EPS =3.00 21.192.42% $4.60 1996 $1.1114 .42% $371.06 = -48.81% Illustration 19: The Effect of size on growth: Amgen Amgen increased its net income from $19.42% $2.42% $1.

For these recommendations the price changes are sustained. 4. Buy recommendations affect prices less than sell recommendations. 13.7% 34. Studies examining how effective analysts are conclude the following ñ y y On average. The prices tend to drift back to their original levels.8% for the sells). Expected Growth And Fundamentals Retention Ratio and Return on Equity gt = Retained Earningst-1/ NIt-1 * ROE = Retention Ratio * ROE = b * ROE . III.4% for buys.7% on sells).8% 1969-79 Are some analysts more equal than others? Some analysts are better at predicting earnings than other analysts. They are also usually better at picking stocks.4% 32.4% 19.Mean Relative Absolute Error Study Analyst Group Analyst Mechanical Forecasts Models Collins & Hopwood Value Line Forecasts 31.1% 1970-74 Brown & Rozeff Value Line Forecasts 28. analysts affect stock prices with their recommendations.2% 1972-75 Fried & Givoly Earnings Forecaster 16. and they continue to rise in the following period (2. The recommendations made by the ëbestí analysts (Institutional Investorís All American Analysts) have a greater impact on stock prices (3% on buys.

255-.26 = (11700*(.5% Growth Rate = 0.i (1-t)) .72%.32% A drop in the return on equity of 0.52*0.Proposition 1: The expected growth rate in earnings for a company cannot exceed its return on equity in the long term. Short term changes in ROE Small changes in return on equity can lead to large shifts in the growth rate for some firms. 1994 1995 BV of Equity 11700 Net Income 3010 Retention Ratio 52.52% + 0.52*0.5% translates into a drop in the growth rate of 2.ROEt-1) / NIt-1]+ b * ROE Illustration 20: Changes in ROE and growth rates: Merck Inc. The following table provides information on the retention ratio and the return on equity for Merck for 1994 and projections for 1995.26)/3010) = 13. If the ROE drops by 2% the expected growth rate in 1995 would be 4. ROE and Leverage ROE = ROA + D/E (ROA .00% 52% Return on Equity 26. The relationship between growth rates and changes in return on equity is as follows ñ gt = [BV of Equityt-1 * (ROEt .20%.0% 25.255 = 11.

6851 to 1.t) / BV of Total Assets D/E = BV of Debt/ BV of Equity i = Interest Expense on Debt / BV of Debt t = Tax rate on ordinary income Note that BV of Assets = BV of Debt + BV of Equity.00% Total Assets $17. Return on Assets.43% 7. ROA = (Net Income + Interest (1 .tax rate) $ 2181 Sales $ 29. after-tax profit margin 7.362 Pre-interest.tax rate)) / BV of Total Assets = EBIT (1.424 Asset Turnover 1. after-tax profit margin is expected to drop from 7. The following table provides projections in profit margins.6851 1.where. asset turnover and growth rates after the shift in corporate strategy: 1992 After shift in strategy EBIT (1.43% to 7% as a consequence and the asset turnover is expected to increase from 1. The pre-interest. Profit Margin and Asset Turnover ROA = EBIT (1-t) / Total Assets = [EBIT (1-t) / Sales] * [Sales/Total Assets] = Pre-interest profit margin * Asset Turnover Illustration 22: Evaluating the effects of corporate strategy on growth rate and value: Procter and Gamble Procter & Gamble decided to reduce prices on their disposable diapers in April 1993 to compete better with low-price private label brands.80.80 .

with earnings per share available from 1987 to 1992.5% 15% Debt/Equity 0% 25% Interest rate on debt 10% 8.89 1988 $1.60% Retention Ratio 58.00% .48% 1990 $2.52% 12. Historical EPS Analyst Estimates Growth Year EPS Rate 1987 $0.tax rate) 4. a cosmetics manufacturer.69% 1989 $1. Consider Autodesk Inc.00% 12.66% 10. The following table also provides analyst forecasts of expected growth over the next five years from nine analysts following Autodesk.43% 1992 $1.30 20.00% Debt/Equity 0.50% 13.00% Growth Rate 14.375% Illustration 24: Weighting based upon standard deviations: Autodesk Inc.31 0.50% 12.91 41.27% Growth Rate 10.74% Illustration 23: Adjusting inputs for firm type: Neutrogena Inc.7108 Interest rate on debt (1 .a software company.00% 58.00% 16. Growth phase Steady State Retention Ratio 76% 50% Return on Assets 19.82% 8.35 51. The following table provides estimates of return on assets.42% 1991 $2. Neutrogena is expected to grow at an extraordinary rate in the first five years (growth phase) and at a stable rate after that (steady state).Return on Assets 12.29% Analyst Number 1 2 3 4 5 6 7 Estimated Growth 10.00% 16. retention ratio and interest rates for Neutrogena.98 -14.00% 10.27% 4.7108 0.

8 18.95% Consensus Forecast = 14% Standard Deviation = 27.00% Arithmetic mean = 19.49% Standard Deviation = 3.45% .

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